Tuesday, August 25, 2009

How Much House Can You Really Afford?

The recommended maximum debt levels for homeowners have always sounded high to me. But this has been little more than a feeling until I looked over some old numbers from when I bought my first house. This exercise has confirmed for me that the maximum debt levels are alarmingly high.

According to the Canada Mortgage and Housing Corporation, housing costs (including mortgage payments, property taxes, and heating expenses) should not exceed 32% of your gross income. When other payments on such things as car loans, lines of credit, and credit cards are added in, the total should not exceed 40% of your gross income.

I agree that people shouldn’t exceed these levels, but how sensible is it to even come close to these percentages? I decided to compare these figures to my own experience buying my first house.

My wife and I had a 27% down payment, and although the mortgage amount looks small now, it was scary for us back then. We spent a little more on the house than we planned to (as many first-time home buyers do). The monthly mortgage payment seemed large, but we were confident that we could handle it.

Adding in property taxes and heating, our initial housing costs were 22% of our income. This put us well below the 32% limit. We had no other debts, and so we were at just over half of the overall 40% debt load limit.

Because we were very nervous about being in debt, we put on a full-court press to pay off the mortgage. For the first two and a half years we took advantage of all the extra payment features of our mortgage including extra amounts each month and a lump sum each year.

Over those first two and a half years, the total of our mortgage payments, extra payments, property taxes, and heating payments were almost exactly 40% of our income. This was the best we were able to do during a period with favourable conditions: we weren’t long out of school and were used to living frugally, and we didn’t have any children yet.

To have started out with payments adding up to 40% of income would have been madness. The slightest hiccup would have sent us off the rails. As it turned out, we couldn’t sustain the pace we had set once we had our first child. After that we reduced our mortgage payments to less than half of what we had been paying.

Prospective homeowners should seriously consider buying much less house than the experts say they can afford.


  1. I heard stories of couples with 100k gross income is buying a 500k to 600k house in Toronto. Everyone is optimistic about the Canadian housing market, which is a strong contrast to overall bearishness of US housing market.

    Do you think that this points to a housing bubble in Toronto and Vancouver?

  2. Henry: I don't know if we're heading into a housing bubble in any part of the country, but things rarely end well for people who take on too big a mortgage and can't make the payments.

  3. Ouch, close to home here. My wife and I make about $130K a year and bought a $450K house in Toronto, with a $60K downpayment. The good news is we have no other debts. I think one of the things that lets me sleep at night is that coworkers who bought out in King City (because it's cheaper) have a 2 hour daily commute and their travelling expenses aren't capitalized, whereas at least my mortgage payments are reducing my overall debt. It's not very easy to live and work in a big city sometimes. And no, I don't think there's a major housing bubble underway at least in the city proper, though I think a minor 5-10% correction is likely at some point. One other thing to consider is that houses 'in the burbs' aren't cheap like they used to be either, and quite frankly I'll take my 1300 sq.ft house over a 3000 sq.ft house monstrosity anyday (not to mention having to pay utilities and furnish that big a house). So, I think there's more to affording a house than simple purchase price, there's the other factors involved that affect the total of how much you pay (ie a go train pass is about $200 a month I hear).

  4. Novice: Based on the numbers you gave, your starting mortgage was 3 years of gross income. This is high, but not impossible to deal with when interest rates are low. Having no other debts is a big plus. I assume that means you have no car payments either. To stay afloat, you should also be saving up to pay cash for your next car. Any "found money" should become an emergency cash reserve, and if that is already full, consider throwing found money against the principal of your mortgage. If interest rates rise any time in the next decade it will put some pressure on you.

  5. MJ thanks for the advice. Our paid for car is a 2002 well maintained Mazda with only 60K on it (benefits of city living) so I'm hoping to get at least another 5 years out of it. What is killer is daycare costs are hefty ($1300 a month) but we're managing. We put 20% more each mortgage payment than required, and have a standard 25 year term. I am expecting rates to rise again but am not too concerned. Houses in my neighbourhood sell quickly, and we bought a house that's suitable for us for the next 20 years, including one more child. We have a limited emergency fund ($5000) and about $36000 in RRSP. We also spent about $15000 renovating and furnishing the place (all paid in cash) so hopefully all the 'must-dos' are done and the wants remain. We do have the option, if it really comes down to it, of going carless for a couple years in a couple years, though it's something I'm loathe to do (again, city living).

  6. Michael James: In Canada, you are not allowed to short sale the house. I am concerned that people who no longer are able to support their debt including mortgage, LOCs, and credit cards in Canada will go through bankruptcy in droves. Not only CHMC (part of Government of Canada) will have to pay out the insurance on defaulted mortgages, banks will have to write down their loans on various LOCs, credit cards, and uninsured mortgages. In a way, this can be worse than what happened in the US, since a lot of people only shortsale their house but do not default on other debts.

    Novice: Your situation seems to be ok due to your family's high gross income.

    Lets compare your case to a couple with 100k gross income that bought a 500k house with 5% downpayment and CHMC insurance.

    Your house to gross income ratio is 3.46, which is much lower than the 5 that this couple has. Ideally, it should be 3 or less.

    Your downpayment is about 13%, which is much more than a 5% downpayment. From the information that you have given out, it sounds that you do not need CHMC insurance, which saves a lot of money in comparison with this couple.

    Depending on the location, you may be right that the worst case scenario is 5% to 10% correction. A 10% correction on your house will not wipe out your downpayment, which is good.

    According to CHMC mortgage calculator, you are able to afford a 1.2 million house with 130k gross income and 60k downpayment. According to CHMC, you can afford a monthly mortgage payment of 4,966. I think your situation sounds fine and CHMC mortgage calculator needs to be redesigned.

  7. Novice: It sounds like you're on a good path. A job loss would put a major strain on your finances, but at least the $1300 per month for daycare would go away.

    Henry: I agree that mortgage calculators should be redesigned. Maybe a green/yellow/red system would work here. Right now they just give you a maximum amount, which is just green/red; either the house you want is below the maximum (green zone) or above the maximum (red zone). I think it would make sense to change the top end of the green zone to yellow. Hopefully this would make people think a little before burying themselves with debt.

  8. One of the problems with the 40% 'rule' is that for folks like me who only see about 55% of their gross due to deductions (pension, health plan, professional dues, etc.) is there is very little left at the end of the month to pay other costs. The bank will happily loan you more that you can afford to repay. For most folks, the debt costs are not tax deductible, the calculator should be based on NET income, not gross. If it were, the whole issue goes away!


  9. No Debt Guy: So, if you have a good credit score, CMHC will allow you to bury yourself in debt with little hope of digging yourself out in less than 3 decades. Nice.

    1. The comment above is a reply to No Debt Guy's comment:

      If your credit score is 680 or greater CHMC will let you have a TDS of 44% and there is no GDS to consider.

      If you have paid off your vehicles, credit cards, loans and have no other debts CHMC says your housing costs, mortgage, taxes and heat can eat up 44% of your gross income.

      Evaluating this a little further a person or couple could buy a $500,000 home with 5% down, amortize it over 35 years with a yearly income of less than $70K.

      Wow, is all I can say.

  10. I work for a credit union and from a business perspective we are quite happy to see the housing market moving again. However, we do caution our members when they are buying the largest hosue they can afford. Mortgages rates right now are at incredible lows. Over the past 50 years the average 5 year rate has been over 8.5%, and even two years ago it was over 6%. If the rate goes towards average, moving the rate from 4.5% up to 8%, we ask members how they will be able to handle the increased monthly pament. Most people simply laugh it off and go ahead with the largest mortgage they can anyway, but we are trying to warn them. We feel it is both good service and risk management on our part.

  11. Anonymous: Warning people about the possible dangers of overextending themselves with debt is what I had in mind with a green/yellow/red system. Instead of just telling people yes or no when it comes to borrowing, it makes sense to tell warn them when they are in the "yellow" zone just short of not being approved. From what you said, it seems that you are trying to do something similar. Your concerns about low interest rates make sense to me as well. Just because borrowers can afford payments now doesn't mean that they will be able to afford them in five years if rates jump a few percent.

  12. My SO and I have just purchased our first home (closing on 09/28) and it was an interesting process.

    We gross about 85k a year and have little debt (car payment, no cc's) and got approved for $315k. I balked at that amount. We have been looking at houses for $200k and under and were worried the purse strings would be tight.

    However, the house that we did settle on was purchased for $215k. Slightly higher than what we wanted to spend but all of the tangibles included will be worth it.

    Even going with 15k over budget, we are at about 23%. Still quite a bit lower than the standard 32%.

    I never understood why that calculation requires your gross income. It seems to me your net income would be a better indicator on what you can/cannot afford.

  13. Hello and thanks for the article. I think that you made a very important point and that is living in debt. People often overestimate their abilities to pay mortgages and then, suddenly, find out that they're in debt unable to pay what they owe. People really should consider well the advantages and disadvantages of taking a mortgage and the amount of money they will have to pay.

    Take care,